To briefly summarize this long post: the creation of knowledge through fundamental research is a public good. Economic theory is clear that public goods will be under-provided without government funding. And as government funding for higher education continues to shrink, it is increasingly the students and their families who are paying for the provision of a good that benefits everyone. Is that really what we want?

First, some background. When economists speak of “public goods,” we have something specific in mind: goods that, once produced, are “non-rival” and “non-excludable.” In plain English, “non-rival” simply means that one person’s consumption of the good does not diminish other people’s ability to use the good. For example, the fact that I get to enjoy a fireworks show or the protection of a missile defense system does not prohibit my neighbor from also enjoying benefits from these goods. This is in contrast to most usual consumption goods – for example, if eat a candy bar, it is impossible for someone else to then eat the same candy bar. “Non-excludable” means, roughly, that once the good is made available, it is available to everyone. A classic example of a public good is clean air in a city: my breathing the clean air does not prevent you from also enjoying it, and it is also difficult to exclude people from breathing the clean air when they are in the city.

A many-decades old and quite famous result in economic theory is that public goods are under-provided in a private market. In essence, I might be able to contribute a little bit to the creation of clean air insofar as the net benefits to me of my efforts are positive. But in making that calculation, I will fail to take into account the benefits on everyone else. They will do the same. So we will effectively end up with too little clean air. It is a special case of market failure where – (tea partiers should cover your ears) – government intervention can actually do a better job of approximating the efficient market solution than free markets.

Universities are in the business of creating several goods that are, at least partially, public goods. The most obvious of these is the creation of knowledge. Indeed, the mission statement here at the University of Illinois lists “creating knowledge” as one of the three central tenants for our existence. In contrast to applied research – such as pharmaceutical company investing in R&D for a new drug – most of the knowledge created in our universities is “fundamental research” – sometimes called “basic research” (although basic is meant to mean fundamental, not easy!) What distinguishes this type of research is that the ultimate goal is not a marketable product, but rather the advancement of knowledge itself. While this knowledge often leads to tangible benefits that can be commercially viable down the line (e.g., two famous Illinois examples include the MRI and web-browser technology), much of the cutting edge research does not have commercial applications. But it is extremely valuable nonetheless.

A great competitive advantage of the U.S. over the past century has been its system of public and private research universities. Indeed, this is one of the “secret sauces” that launched the United States into a world economic powerhouse over the past century. Universities have been responsible for much of the technological and intellectual innovation that has shaped the world in which we live. The fact that our standard-of-living is many times higher today than it was a century ago is due – in part – to our outstanding research universities.

Historically, much of this research has been supported by public dollars. At public and private research institutions, much direct research funding has come from federal agencies such as the National Science Foundation, the National Institute of Health, as well as research funding from other cabinet agencies (e.g., Department of Energy, Department of Defense). At public institutions, support has also traditionally come from state appropriations to support both the teaching and research missions of public universities. For example, state funding has long been an important source of funds to pay faculty salaries, and it is those faculty who are, in turn, creating knowledge.

That model, however, is coming under increasing strain. Thanks to enormous fiscal imbalances at the federal and state levels, many traditional sources of public support for higher education are declining. Perhaps the most notable of these is the decline in state appropriations that support public research institutions. Here at Illinois, our Chief Financial Officer, Walter Knorr, remarked in March that the, “the state’s direct appropriation to the university is 26 percent below what it was 40 years ago, when adjusted for inflation.”

One of the leading experts on the economics of higher education, Ron Ehrenberg of Cornell University, has written extensively on changing nature of higher ed funding over the decades. In a 2003 paper titled, “Who Bears the Growing Cost of Science at Universities,” he notes that ”while undergraduate students may benefit from being in close proximity to great researchers, they also bear part of the growing costs of research in the form of larger class sizes, fewer full-time professorial rank faculty members and higher tuition levels.”

Since his paper was written, tuition rates have continued to climb, largely in an attempt to offset declining public sector support. In essence, students and their families are footing a larger share of the bill for the creation of knowledge.

To be clear, I am not saying that students are getting a bad deal for their tuition dollars. Indeed, every study of the returns to a college education reinforce that – at least on average – a college degree continues to be one of the best investments an individual can ever make. This remains true even as tuition rates climb. And it is also the case that students enrolled at research institutions benefit from interacting with faculty who excel at knowledge creation. Clearly, students and their families agree that an Illinois degree is still a phenomenal investment, as indicated by the fact that applications to the University continue to jump, even in the face of tuition hikes.

Nonetheless, these are troubling trends. If knowledge creation is central to our national well-being and economic growth, then we need to ensure it is supplied at the optimal level. It should not be limited by the willingness and ability of students and their families to pay to for a university education.

Earlier this year, I made a post (click here) in which I suggested that universities might wish to increase their spending out of endowments to help maintain, during an economic downturn, their investment in high-value projects (such as recruiting and retaining top faculty and staff). Such an approach would be consistent with one possible view of endowments – that they are to serve as a buffer stock or an insurance policy against bad economic times. Some of the comments I received – as well as a post (click here) by my colleague David Ikenberry – were less enamored of this idea.

Now, I have research to indicate that most universities, in fact, do NOT behave this way. Rather, it appears that when universities suffer negative shocks to their endowments, they actually reduce the rate of spending from their endowment beyond what would be implied by their own spending rules. In essence, they do not use endowments to protect their universities from larger spending cuts. Instead, they appear to act in a manner consistent with trying to preserve the value of the endowment for its own sake.

Our research goes on to show that following endowment shocks, universities respond by cutting staff – including maintenance workers and secretaries. Less prestigious schools tend to reduce tenured and tenure track faculty (most likely by not replacing those who retire or leave), whereas more selective institutions tend to do more to protect their tenure-system faculty. The only group that is unaffected by the shock is “administrators.”

We also find that when an endowment invests more of its resources in alternative asset classes – things like private equity, hedge funds, timber, commodities, and the like – universities make even larger cuts following a negative endowment shock. This could be for one of two possible reasons. First, these alternative asset classes are more illiquid, and thus not easy to access during down markets. Second, it may be that the reported value of these assets – which are much harder to value than, say, publicly traded stocks – are overstated, and the endowment knows it (or at least suspects it).

These results suggest that university faculty and staff have a clear stake in decisions about how endowments are invested and in the payout policies.

If you would like to read more about this, I can refer you to the paper itself (click here) or to a write-up about the paper that appeared in “Inside Higher Ed” (click here).

In 2008, the federal government’s receipts were 17% of GNP, and its expenditures including transfer payments were 21.4% of GNP (implying the budget deficit was 4.4% of GNP). If State and Local taxes and expenditures are added to those numbers, they become 30.5% and 35.2% of GNP, respectively. For many reasons, however, government’s reach is wider than reflected in those numbers. Government does not just spend its own tax revenue; it spends other people’s money as well.

For just one example, consider environmental regulations. I have not seen a recent estimate of the total costs of environmental protection, so I will rely on some older numbers. Note, however, than none of this discussion is meant to imply that the environment should not be protected! Maybe protections should be more limited, or expanded. The point is just that measured dollar expenditure by government does not accurately reflect its true size.

In “The Cost of Clean”, the U.S. EPA in 1990 estimated that the total private cost of required environmental protection was approximately $115 billion (in 1990 dollars) or 2.1% of GNP. By the year 2000, they said the value could approach 2.8% of GNP. If I assume the same rate of growth through 2008, then these private costs of environmental protection could be as high as 3.5% of GNP by 2008, a figure that would be $514.0 billion, or 21.6% of non-defense federal expenditures.

This cost of environmental protection comes mainly in the form of mandates imposed on firms. Examples of mandates include the forced adoption of best practices pollution abatement technology or binding emission rates (e.g. limits on pollution per unit of output). However, these mandates are just like taxes in two respects. First, the government imposes these costs on private firms. Second, the mandates provide “public goods” like clean air and water that we all can enjoy.

In other words, if these costs to private firms were converted into an equivalent tax program with direct government expenditures, then U.S. discretionary spending would appear to be 21.6% higher. These expenditures do not appear explicitly in the federal budget, so they merit further study. How do we divide our limited resources between private or public consumption, versus private or public investment? How much of that environmental spending is in each category? What are we getting for these outlays? How can we measure the value of the improved environment? Do these expenditures provide environmental benefits now, or are they investment in the future?

In order address these questions, a full “environmental budget” would need to show each cost, including the cost of complexity created by mandates. In addition, some environmental protection programs are required by state and local governments (just like taxes). Each of the programs has implicit transfers from one state to another, and from one income group to another (just like taxes). Why are these programs not evaluated just like taxes?